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DISCOUNT RATES
John H. Cochrane
Working Paper 16972
http://www.nber.org/papers/w16972
I thank John Campbell, George Constantnides, Doug Diamond, Gene Fama, Zhiguo He, Bryan Kelly,
Juhani Linnanmaa, Toby Moskowitz, Lubos Pastor, Monika Piazzesi, Amit Seru, Luis Viceira, Lu
Zhang and Guofu Zhou for very helpful comments. I gratefully acknowledge research support from
CRSP and outstanding research assistance from Yoshio Nozawa. The views expressed herein are those
of the author and do not necessarily reflect the views of the National Bureau of Economic Research.
NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official
NBER publications.
2011 by John H. Cochrane. All rights reserved. Short sections of text, not to exceed two paragraphs,
may be quoted without explicit permission provided that full credit, including notice, is given to
the source.
Discount Rates
John H. Cochrane
NBER Working Paper No. 16972
April 2011
JEL No. G0
ABSTRACT
Discount rate variation is the central organizing question of current asset pricing research. I survey
facts, theories and applications. We thought returns were uncorrelated over time, so variation in price-dividend
ratios was due to variation in expected cashflows. Now it seems all price-dividend variation corresponds
to discount-rate variation. We thought that the cross-section of expected returns came from the CAPM.
Now we have a zoo of new factors. I categorize discount-rate theories based on central ingredients
and data sources. Discount-rate variation continues to change finance applications, including portfolio
theory, accounting, cost of capital, capital structure, compensation, and macroeconomics.
John H. Cochrane
Booth School of Business
University of Chicago
5807 S. Woodlawn
Chicago, IL 60637
and NBER
john.cochrane@chicagobooth.edu
I. Introduction
Asset prices should equal expected discounted cashflows. 40 years ago, Gene Fama (1970)
argued that the expected part, testing market eciency, provided the framework for organizing asset-pricing research in that era. I argue that the discounted part better organizes
our research today.
I start with facts: How discount rates vary over time and across assets. I turn to theory,
why discount rates vary. Ill attempt a categorization based on central assumptions and
links to data, analogously to Famas weak semi-strong and strong forms of eciency.
Finally, I point to some applications, which I think will be strongly influenced by our new
understanding of discount rates. In each case, I have more questions than answers. This
paper is more of an agenda than a summary.
An apology: In the available space I cannot even cite let alone review all the deserving
literature, or trace the development of all these ideas. Even my long reference list only gives
examples of relevant work.
t()
R2 [ ( )]
3.8 (2.6) 0.09
5.46
20.6 (3.4) 0.28
29.3
[ ( )]
( )
0.76
0.62
= + + + . Annual
Table I. Return-forecasting regressions +
data, CRSP value-weighted return less three-month Treasury return 1947-2009.
The five-year regression t statistic uses the Hansen-Hodrick (1983) correction.
[ ( )] stands for ( ).
The one-year regression forecast doesnt seem that important. Yes, the t statistic is
significant, but there are lots of biases and fishing. The nine percent 2 isnt impressive.
In fact, this regression has huge economic significance. First, the coecient estimate is
large. One percentage point more dividend yield forecasts nearly four percentage points
more return. Prices rise by an additional three percentage points.
1
Second, five and a half percentage point variation in expected returns is a lot. A sixpercent equity premium was already a puzzle.2 The regression implies that expected returns vary by at least as much as their puzzling level.
By contrast, 2 is a poor measure of economic significance in this context3 . The economic
question is How much do expected returns vary over time? There will always be lots of
unforecastable return movement, so the variance of ex-post returns isnt a very informative
comparison for this question.
Third, the slope coecients and 2 rise with horizon. Figure 1 plots each years dividend
yield along with the subsequent seven years of returns. Read the dividend yield as prices
upside down: prices were low in 1980 and high in 2000. The picture then captures the central
fact: High prices, relative to dividends, have reliably led to many years of poor returns. Low
prices have led to high returns.
4 x D/P and Annualized Following 7Year Return
4 x DP
Return
25
20
15
10
1950
1960
1970
1980
1990
2000
2010
Figure 1: Dividend yield (multiplied by 4) and following annualized 7-year return. CRSP
value-weighted market index.
X
=1
1 + + +
=1
(1)
()
()
Just run both sides of the identity (1) on Here, , and denote long-run
regression coecients, i.e.
1 + = + ()
+ +
(3)
=1
()
1 + = + + +
=1
()
+ = + +
+
(4)
If we lived in an i.i.d. world, dividend yields would never vary in the first place. Expected
future returns and dividend growth would never change. If dividend yields vary at all, they
must forecast long-run returns, long-run dividend growth, or a rational bubble of ever
higher prices.
The regression coecients in (2) can be read as the fractions of dividend yield variation
attributed to each source. To see this interpretation more clearly, multiply both sides of (2)
by ( ), giving
#
"
#
"
X
X
( )
1 +
1 + + ( + ) (5)
=1
=1
The empirical question is, which is it? Table II presents long-run regression coecients.
()
()
()
Direct regression , = 15 1.01 -0.11 -0.11
Implied by VAR, = 15 1.05 0.27 0.22
VAR, = 1.35 0.35 0.00
=1
1 + =
The long-run return coecients are all a bit larger than 1.0. The dividend-growth forecasts are small, insignificant, and positive point estimates go the wrong way high prices
relative to current dividends signal low future dividend growth. The 15-year dividend-yield
forecast coecient is also essentially zero, and has the wrong sign as well.
Thus the estimates say that all price-dividend ratio volatility corresponds to variation in
expected returns. None corresponds to variation in expected dividend growth, and none to
rational bubbles.
In the 1970s, we would have guessed exactly the opposite pattern. On the idea that
returns are not predictable, we would have supposed that high prices relative to current
dividends reflect expectations that dividends will rise in the future, and so forecast higher
dividend growth. That pattern is completely absent. Instead, high prices relative to current
dividends entirely forecast low returns.
This is the true meaning of return forecastability.4 This is the real measure of how
big the point estimates are return forecastability is just enough to account for price
volatility. This is the natural set of units with which to evaluate return forecastability.
What we expected to be 0 is 1; what we expected to be 1 is 0.
Table II also reminds us that the point of the return-forecasting project is to understand
prices, the right hand variable of the regression. We put return on the left because the
forecast error is uncorrelated with the forecasting variable. That choice does not reflect
cause and eect, nor does it imply that the point of the exercise is to understand expost return variation.
How you look at things matters. The long-run and short-run regressions are mathematically equivalent. Yet one transformation shows an unexpected economic significance. We
will see this lesson repeated many times.
(Table II does not include standard errors, and sampling variation in long-run estimates
is an important topic.5 My point is the economic importance of estimates. One might still
argue that we cant reject the alternative views. But when point estimates are 1 and 0,
arguing we should believe 0 and 1 because that view cant be rejected is a tough sell.
The variance of dividend yields or price-dividend ratios corresponds entirely to discountrate variation, but as much as half of the variance of price changes +1 = +1 + +
+1 or returns +1 +1 + + +1 corresponds to current dividends +1 . This
fact seems trivial but has caused a lot of confusion.
I divide by dividends for simplicity, to capture a huge literature in one example. Many
other variables work about as well, including earnings and book values.)
4
Shiller (1981), Campbell and Shiller (1988), Campbell and Ammer (1993), Cochrane (1991a), (1992),
(1994) and review in (2005c).
5
See Cochrane (2006) and its references.
C. A pervasive phenomenon
This pattern of predictability is pervasive across markets. For stocks, bonds, credit spreads,
foreign exchange, sovereign debt and houses, a yield or valuation ratio translates one-for-one
to expected excess returns, and does not forecast the cashflow or price change we may have
expected. In each case our view of the facts have changed 100% since the 1970s.
Stocks. Dividend yields forecast returns, not dividend growth.6
Treasuries. A rising yield curve signals better one-year return for long-term bonds, not
higher future interest rates. Fed fund futures signal returns, not changes in the funds
rate.7
Bonds. Much variation of credit spreads over time and across firms or categories signals
returns not default probabilities.8
Foreign exchange. International interest rate spreads signal returns, not exchange-rate
depreciation.9
Sovereign debt. High levels of sovereign or foreign debt signal low returns, not higher
government or trade surpluses.10
Houses. High price/rent ratios signal low returns, not rising rents or prices that rise
forever.
Since houses are so much in the news, Figure 2 shows house prices and rents, and Table III
presents a regression. High prices relative to rents mean low returns, not higher subsequent
rents, or prices that rise forever. The housing regressions are almost the same as the stock
market regressions. (Not everything about house and stock data is the same of course.
Measured house price data are more serially correlated.)
+1
+1
+1
Houses
2
0.12 (2.52) 0.15
0.03 (2.22) 0.07
0.90 (16.2) 0.90
Stocks
2
0.13 (2.61) 0.10
0.04 (0.92) 0.02
0.94 (23.8) 0.91
Table III. Left: Regressions of log annual housing returns +1 , log rent growth
+1 and log rent/price ratio +1 on the rent/price ratio , +1 = +
+ +1 1960-2010. Right: Regressions of log stock returns +1 , dividend
growth +1 and dividend yields +1 on dividend yields , annual CRSP
value weighted return data 1947-2010.
6
20 x rent
CSW price
OFHEOprice
7.8
Price
log scale
7.6
7.4
7.2
20 x Rent
6.8
1960
1970
1980
1990
2000
2010
Date
Figure 2: House prices and rents. OFHEO is the Oce of Federal Housing Enterprise
Oversight "purchase-only" price index. CSW are Case-Shiller-Weiss price data. Data from
http://www.lincolninst.edu/subcenters/land-values/rent-price-ratio.asp
There is a strong common element and a strong business cycle association to all these
forecasts.11 Low prices and high expected returns hold in bad times, when consumption,
output and investment are low, unemployment is high, businesses are failing, and vice versa.
These facts bring a good deal of structure to the debate over bubbles and excess
volatility. High valuations correspond to low returns, and associated with good economic
conditions. All a price bubble can possibly mean now is that the equivalent discount
rate is too low relative to some theory. Regressions do not establish causality. But this
equivalence channels us to a much more profitable discussion.
We have some additional predictor variables , from similar univariate or at best bivariate
11
(hence [+ ]) explorations,
stock
+1
= [+ ] + + +1
First, then, which of these variables are really important in a multiple regression sense?
In particular, do the variables that forecast one return forecast another?
stock
= + + + 0 + +1 ?
+1
(6)
bond
= + + + 0 + +1 ?
+1
We would see a one-factor model for expected returns, with stock expected returns always
changing by twice bond expected returns,
stock
+1
(7)
= 2 factor
bond
+1
= 1 factor .
Third, we need to relate time-varying expected returns to covariances with pricing factors
or portfolio returns.
0
f+1
)
= (+1
+1
As a small step down this road, Cochrane and Piazzesi (2005) (2008) find that forward
rates of all maturities help to forecast returns of each maturity multiple regressions matter
as in (6). We found that the right-hand sides are almost perfectly correlated across left-hand
maturities.12 A single common factor describes 99.9% of the variance of expected returns as in
(7). Finally, we find that the spread in time-varying expected bond returns across maturities
corresponds to a spread in covariances with a single level factor, and the market prices of
risk of slope, curvature, and expected-return factors are zero.
What similar patterns hold across broad asset classes? The challenge, of course, is that
there are too many right hand variables, so we cant just go run huge multiple regressions.
But these are the vital questions.
12
Hansen and Hodrick (1983) and Stambaugh (1988) find similar structures.
E. Multivariate prices
I advertised much of the point of running return regressions with prices on the right hand
side was to understand those prices. How will a multivariate investigation change our picture
of prices and long-run returns?
Again, the Campbell-Shiller present value identity
X
=1
1 +
1 +
(8)
=1
provides a useful way to think about these questions. Since this identity holds ex-post,
it holds for any information set. Dividend yields are a great forecasting variable because
they reveal market expectations of dividend growth and returns. However, dividend yields
combine the two sources of information. A variable can help the dividend yield to forecast
long-run returns if it also forecasts long-run dividend growth. A variable can also help to
predict one year returns +1 without much changing long-run expected returns, if it has an
osetting eect on longer-run returns {+ }. Such a variable signals a change in the term
structure of risk premia { + }.
I examine Lettau and Ludvigsons (2001a) (2005) consumption to wealth ratio cay as an
example to explore these questions. Table IV presents forecasting regressions
+1
+1
+1
+1
P
1
=
P =11 +
= =1 +
Coecients
0.12 0.071
0.024 0.025
0.94 -0.047
0.15
0.65
1.29 0.033
0.29 0.033
t-statistics
(2.14) (3.19)
(0.46) (1.69)
(20.4) (-3.05)
(0.63) (5.95)
Other statistics
(+1 )]
[ (+1 )] % [
(+1 )
0.26
8.99
0.91
0.05
2.80
0.12
0.91
0.43
0.51
0.12
2
Cay helps to forecast one-period returns. The t statistic is large, and it raises the variation
of expected returns substantially. Cay only marginally helps to forecast dividend growth.
(Lettau and Ludvigson report that it works better in quarterly data.)
Figure 3 graphs the one-year return forecast using dp alone, the one-year return forecast
using dp and cay together, and the actual ex-post return. Adding cay lets us forecast
business-cycle frequency wiggles while not much changing the trend.
40
30
20
10
10
dp and cay
dp only
actual rt+1
20
1950
1960
1970
1980
1990
2000
2010
Figure 3: Forecast and actual 1 year returns. The forecasts are fitted values of regressions
of returns on dividend yield and cay. Actual returns are plotted on the same date as their
forecast, i.e. +1 is plotted at the same date as + .
2.5
lr
E(r |dp,cay)
lr
E(r |dp)
dp
3
3.5
4.5
5
1950
1960
1970
1980
1990
2000
2010
P
1
Figure 4: Dividend yield dp and forecasts of long-run returns
+ Return forecasts
=1
are computed from a VAR including dp, and a VAR including dp and cay.
Long-run return forecasts are quite dierent. Figure 4 contrasts long-run return forecast
with and without cay. Though cay has a dramatic eect on one-period
+1 forecasts
P return
1
in Figure 3, cay has almost no eect at all on long-run return =1 + forecasts in
Figure 4.
Figure 4 includes the actual dividend yield, to show (by (8)) how dividend yields break
into long-run return vs. dividend growth forecasts. The last two rows of Table IV give the
corresponding long-run regression coecients. Essentially all price-dividend variation still
9
Response to dp shock
0.15
return
div growth
shock date
1
0.8
0.07
return
div growth
return
div growth
0.06
j1
0.1
r =1.29
t+j
0.05
j1
0.04
0.6
0.05
j1d =0.29
t+j
0.4
0.2
r =0.033
t+j
0.03
0.02
0.01
0
rt = 0.96
j1d =0.033
t+j
0
0
10
15
20
0.05
0.01
0
Response to d shock
10
15
20
10
15
20
Response to dp shock
0.16
1
0.8
0.6
0.2
price
dividend
0.14
0.2
0.12
0.1
0.08
0.4
0.4
0.06
0.6
0.2
price
dividend
shock date
0
0
10
15
0.04
0.8
20
0.02
price
dividend
1
0
10
15
0
20
10
15
20
Figure 5: Response functions to dividend growth, dividend yield, and cay shocks. Calculations are based on the VAR of Table 4. Each shock changes the indicated variable without changing the others, and includes a contemporaneous return shock +1 =
+1 +1 + . The vertical dashed line indicates the period of the shock.
These plots answer the question, what change in expectations corresponds to the given
shock? The dividend growth shock corresponds to permanently higher expected dividends
with no change in expected returns. Prices jump to their new higher value and stay there. It
is a pure expected cashflow shock. The dividend yield shock is essentially a pure discount
rate shock. It shows a rise in expected returns with little change in expected dividend growth.
The cay shock in the rightmost panel of Figure 5 corresponds to a shift in expected
returns from the distant future to the near future, with a small similar movement in the
timing of a dividend growth forecast. It has almost no eect on long run returns or dividend
10
For impulse-responses, see Cochrane (1994). For the eect of cay, see Lettau and Ludvigson (2005).
11
without beta.14
Fama and French (1993), (1996) brought order once again with size and value factors.
Figure 6 includes the results of multiple regressions on the market and Fama and Frenchs
hml factor,
= + + +
The Figure shows the separate contributions of () and () in accounting
for average returns ( ). Higher average returns do line up well with larger values of the
regression coecient
Average returns and betas
0.8
E(r)
Average return
0.6
b x E(rmrf)
0.4
x E(rmrf)
0.2
h x E(hml)
0
0.2
Growth
Value
Figure 6: Average returns and betas for Fama - French 10 Book/Market sorted portfolios.
Monthly data 1963-2010.
Fama and Frenchs factor model accomplishes a very useful data reduction. Theories
now only have to explain the hml portfolio premium, not the expected returns of individual
assets.15 This lesson has yet to sink in to a lot of empirical work, which still uses the 25
Fama French portfolios to test deeper models.
Covariance is in a sense Fama and Frenchs central result: if the value firms decline, they
all decline together. Its a sensible result: Where there is mean, there must be comovement,
so that Sharpe ratios do not rise without limit in well-diversified value portfolios.16 But
theories now must also explain this common movement among value stocks. It is not enough
to simply generate temporary price movements, a fad that produces high or low prices, and
then fades away rewarding contrarians. You need all the low-price securities to subsequently
rise and fall together in the following month.
Finally, Fama and French found that other sorting variables, such as firm sales growth,
did not each require a new factor. The three-factor model took the place of the CAPM for
14
12
13
alpha, information ratio, and t-statistic, and then see if the spread in means corresponds to
a spread of portfolio betas against some factor. But we cant do this with 27 variables.
Portfolio sorts are really the same thing as nonparametric cross sectional regressions,
using rather inecient non-overlapping histogram weights. Figure 7 illustrates the point.
For one variable, portfolio sorts and regressions both work. But we cant chop portfolios 27
Portfolio
Mean
E(R)
Securities
Better weights?
1
Portfolio
5
Log(Book/market)
= + 0 + +1
+1
(+1
| )
Once we understand expected returns, we have to see if expected returns line up with
covariances of returns with factors. Sorted-portfolio betas are a nonparametric estimate of
20
21
Fama and French (2010) already run such regressions, despite evident reservations over functional forms.
Cochrane (2005c).
14
(+1
+1 ) = ( )
Parametric approaches are natural here as well, to address a multidimensional world. For
example, we can run regressions
+1 (+1
| ) +1 = + 0 + +1 () = + 0
(The errors may not be normal, but they are mean-zero and uncorrelated with the right
hand variable.) We want to see if the mean return function lines up with the covariance
function.
( |) = () ?
Underlying everything were doing is an assumption that expected returns, variances and
covariances are stable functions of characteristics, not (say) security name. Thats why we
use portfolios in the first place. That is an incredibly useful assumptionor, fact about the
world. Without it, its hard to tell if there is any spread in average returns at all. It means
however, that asset pricing really is about the equality of two functions; the function relating
means to characteristics and the function relating covariance to characteristics.
Looking at portfolio average returns rather than forecasting regressions was really the
key to understanding economic importance of many eects, as was looking at long-horizon
returns. For example, serial correlation with an 2 of 0.01 doesnt seem that impressive. Yet
is enough to account for momentum: The last years winners went up 100%, so an annual
autocorrelation of 0.1, meaning 0.01 2 , generates a 10% annual portfolio mean return.
(An even smaller amount of time-series cross-correlation works as well.) As another classic
example, Lustig, Roussanov, and Verdelhan (2010a) translated carry-trade return-forecasting
regressions to means of portfolios formed on the basis of currency interest dierentials. This
step led them to look for and find a factor structure of country returns that depends on
interest dierentials, a high minus low factor. This step followed Fama and French (1996)
exactly, but no one thought to look for it in 30 years of running country-by-country timeseries forecasting regressions
But the equivalence of portfolio sorts and regressions goes both ways. We can still calculate these measures of economic significance if we estimate panel-data regressions for means
and covariances. From the spread of lagged returns, we can calculate the momentum portfolio implications directly. The 1-10 portfolio information ratio is the same thing as the Sharpe
ratio of the underlying factor, or t-statistic of the cross-sectional regression coecient. (See
the Appendix.) We could study the covariance structure of panel-data regression residuals as
a function of the same characteristics (interest rate spread, for example) rather than actually
form portfolios,
(+1
+1
) = ( )
Running multiple panel-data forecasting regressions is full of pitfalls of course. One
can end up focusing on tiny firms, or outliers. One can get the functional form wrong.
Uniting time-series and cross section will yield new insights as well. For example, variation
in book/market over time for a given portfolio has a larger eect on returns than variation
15
in book/market across the Fama-French portfolios, and a recent change in book/market also
seems to forecast returns. (See the Appendix.) I didnt say it will be easy! But we must
address the factor zoo, and I dont see how to do it by a high-dimensional portfolio sort.
C. Prices
Then, we have to answer the central question, what is the source of price variation?
When did our field stop being asset pricing and become asset expected returning?
Why are betas exogenous?22 A lot of price variation comes from discount factor news. What
sense does it make to explain expected returns by the covariation of expected return shocks
with market expected return shocks? Market/book ratios should be our left-hand variable,
the thing were trying to explain, not a sorting characteristic for expected returns.
Focusing on expected returns and betas rather than prices and discounted cashflows
makes sense in a two-period or i.i.d. world, since in that case betas are all cashflow betas.
It makes much less sense in a time-varying discount rate world.
A long-run, price-and-payo perspective may also end up being simpler. As a hint of the
possibility, solve the Campbell-Shiller identity for long-run returns,
1 + =
=1
X
=1
1 +
So, long-run return uncertainty all comes from cashflow uncertainty. Long-run betas are all
cashflow betas. The long run looks just like a simple one-period model with a liquidating
dividend.
+1
+1
=
+1 =
+1 = +1
A natural start is to forecast long-run returns and form price decompositions in the cross
section, just as in the time-series; estimate forecasts such as
1 +
= + 0 +
=1
and then understand valuations with present value models as before.23 (The Appendix
includes two simple examples.)
In a formal sense, of course,
doesnt matter whether you look at returns or prices.
Pit
16
view than focusing on short-run returns. What constitutes a big or small error is also
dierent if we look at prices vs. returns. At a 2% dividend yield, = ( ) implies
that an insignificant 10bp/month expected return error is a large 12% price error, if it is
permanent. For example, since momentum amounts to a very small time-series correlation
and lasts less than a year, I suspect it has little eect on long-run expected returns and
hence the level of stock prices. Long-lasting characteristics are likely to be more important.
Conversely, small transient price errors can have a large impact on return measures. A tiny
i.i.d. price error induces the appearance of mean reversion where there is none. Common
procedures amount to taking many dierences of prices, which amplify the error/signal ratio.
()
(1)
(1)
()
(1)
For example, the forward spread =
+ is already a triple-dierence
of price data.
IV. Theories
Having viewed a bit of how discount rates vary, Lets think now about why discount rates
vary so much.
+1
( + 1)
=
+1 =
;
()
(+1
) = (+1
+1 ) (+1
+1 )
High expected returns (low prices) correspond to securities that pay o poorly when consumption is low. This model combines frictionless markets, rational expectations and utility
maximization, and risk sharing so that only aggregate risks matter for pricing. It evidently
ties discount rate variation to macroeconomic data.
A vast literature has generalized this framework, including (among others)24 1) Nonseparability across goods durable and nondurable25 ; traded and nontraded; 2) Nonseparability
over time, such as habit persistence,26 3) Recursive utility and long-run risks27 4) Rare
disasters, which alter measurements of means and covariances in short samples28 .
A related category of theories adds incomplete markets or frictions preventing some
consumers from participating. Though they include frictions, I categorize such models
here because asset prices are still tied to some fundamental consumer or investors economic
outcomes. For example, if non-stockholders do not participate, we still tie asset prices to the
consumption decisions of stockholders who do participate.29
With incomplete markets, consumers still share risks as much as possible. The completemarket theorem that all risks are shared, marginal utility is equated across people and ,
+1 = +1 , becomes all risks are shared as much as possible. The projection of marginal
utility on asset payos is the same across people (+1 |) = (+1 |) . We
can still aggregate marginal utility rather than aggregate Rconsumption before constructing
marginal utility. A discount factor +1 = +1 (+1 ) = ()+1 prices assets, where
+1 takes averages across people conditional on aggregates. For example with power utility
we have
"
#
+1
+1 = +1
24
18
The fact that we aggregate nonlinearly across people means that variation in the distribution
of consumption matter to asset prices. Times in which there is more cross-sectional risk will
be high-discount factor events.30
Outside or nontradeable risks are a related idea. If a mass of investors has jobs or
businesses that will be hurt especially hard by a recession, they avoid stocks that fall more
than average in a recession.31 Average stock returns then reflect the tendency to fall more
in a recession, in addition to market risk exposure. Though in principle, given a utility
function, one could see such risks in consumption data, individual consumption data will
always be so poorly measured that tying asset prices to more fundamental sources of risk
may be more productive.
If we ask the representative investor in December 2008 why he or she is ignoring the
high premiums oered by stocks and especially fixed income, the answer might well be thats
nice, but Im about to lose my job, and my business might go under. I cant take any more
risks right now, especially in securities that will lose value or become hard to sell if the
recession gets worse. These extensions of the consumption-based model all formalize this
sensible intuition as opposed to the idea that these consumers have wrong expectations,
or that they would have been happy to take risks but intermediaries were making all asset
pricing decisions for them.
Investment-based models link asset prices to firms investment decisions, and general equilibrium models include production technologies and a specification of the source of shocks.
This is clearly the ambitious goal towards which we are all aiming. The latter tries to answer
the vexing questions, where do betas come from? What makes a company a growth or
value company in the first place?32
I think behavioral asset pricings central idea is that peoples expectations are wrong.33
It takes lessons from psychology to find systematic patterns to the wrong expectations.
There are some frictions in many behavioral models, but these are largely secondary and
defensive, to keep risk-neutral rational arbitrageurs from coming in and undoing the behavioral biases. Often, simple risk aversion by the rational arbitrageurs would serve as well.
Behavioral models, like rational models, tie asset prices to the fundamental investors
willingness, ability or (in this case) perception of risk.
Behavioral theories are also discount-rate theories. A distorted probability with riskfree
discounting is mathematically equivalent to a dierent discount rate.
=
1 X
where
=
30
0 0
19
Fama (1998).
For example, which of Epstein and Zin (1989), Barberis, Santos, and Huang (2001), Hansen and Sargent
(2005), Laibson (1997), Hansen, Heaton and Li (2008), and Campbell and Cochrane (1999) is really rational
and which is really behavioral?
35
20
21
Segmentedmarkets
Securityclass
Securityclass
?
Investor
Investor
Investor
Investor
Investor
Intermediatedmarkets
Securities
Intermediary
Equity
Debt
Investor
Investor
Otherassets
Mitchell, Pedersen and Pulvino (2007) is a good example. They document who was active in convertible
arbitrage markets through two episodes in which the specialized hedge funds left the market and it took
months for the multi-strategy funds to move in.
22
We have long recognized that some assets have higher or lower discount rates in compensation for greater or lesser liquidity.43 We have also long struggled to define and measure
liquidity. There are (at least) three kinds of stories for liquidity that are worth distinguishing. Liquidity can refer to the ease of buying and selling an individual security. Illiquidity
can also be systemic: assets will face a higher discount rate if their prices fall when the
market as a whole is illiquid, whether or not the asset becomes more or less illiquid. Finally, assets can have lower discount rates if they facilitate information trading, as money
facilitates physical trading.
I think of liquidity as dierent from segmentation in that segmentation is about
limited risk-bearing ability, while liquidity is about trading. Liquidity is a feature of assets,
not the risks to which they are claims. Many theories of liquidity emphasize asymmetric
information, not limited risk-bearing ability assets become illiquid when traders suspect
that anyone buying or selling knows something, not because traders are holding too much
of a well-understood risk. Understanding liquidity requires us to unravel the puzzle of why
people and institutions trade so vastly more than they do in our models.
All of these facts and theories are really about discount rates, expected returns, risk
bearing, risk sharing and risk premiums. None are fundamentally about slow or imperfect
diusion of cash-flow information, i.e. informational ineciency. Informational eciency
isnt wrong or disproved. Eciency basically won, and we moved on. When we see information, it is quickly incorporated in asset prices. There is a lot of asset-price movement not
related to visible information, but Hayek (1945) told us that would happen, and we learned
that a lot of such price variation corresponds to expected returns. Little of the (large) gulf
between the above models is really about information. Seeing the facts and the models as
categories of discount-rate variation seems much more descriptive of most (not all) theory
and empirical work.
Informational eciency is much easier for markets and models to obtain than wide risk
sharing or desegmentation, which is perhaps why it holds more broadly. A market can
become ecient with only one informed trader, who doesnt need to actually buy anything
or take any risk. He should run in to a wall of indexers, and end up just bidding up the asset
he knows is underpriced.44 Though price discovery seems in reality to come with a lot of
trading, it doesnt have to do so. Risk sharing needs everyone to change their portfolios and
bear a risk in order to eliminate segmentation. For example, if the small firm eect came
from segmentation, the passively-managed small stock fund or total market fund should have
ended it but it also took the invention and marketing of such funds to end it. The actions
of small numbers of arbitrageurs could not do so.
B. Recent performance
This is not the place for a deep review of theory and empirical work supporting or confronting
theories. Instead, I think it will be more productive to think informally about how these
43
Acharya and Pedersen (2005), Amihud, Mendelson and Pedersen (2005), Cochrane (2005b), Pastor and
Stambaugh (2003), Vayanos and Wang (2011).
44
Milgrom and Stokey (1982).
23
C. Consumption
I still think the macro-finance approach is promising. Figure 9 presents the market pricedividend ratio, and aggregate consumption relative to a slow-moving habit. The habit is
basically just a long moving average of lagged consumption, so the surplus consumption ratio
line is basically detrended consumption.45
Surplus consumption (CX)/C and stocks
P/D
SPC (CX)/C
1990
1992
1995
1997
2000
2002
2005
2007
2010
24
ratio. The fit isnt perfect, but the general pattern is remarkably good, given the hue and
cry about how the crisis invalidates all traditional finance.
D. Investment
The Q theory of investment is the o-the-shelf analogue to the simple power-utility model
from the producer point of view. It predicts that investment should be low when valuations
(market to book) are low, and vice versa,
1+
market value
=
=
book value
(9)
2.5
1.5
1
1990
1992
1995
1997
2000
2002
2005
2007
2010
Figure 10: Investment/capital ratio, price/dividend ratio, and market/book ratio. Investment is real private nonresidential fixed investment. Capital is cumulated from investment
with an assumed 10% annual depreciation rate. Price/dividend from CRSP, market/book
from Ken Frenchs website.
Figure 10 contrasts the investment/capital ratio, market/book ratio, and price/dividend
ratio. The simple Q theory also links asset prices and investment better than you probably
thought, both in the tech boom and the financial crisis.
Many finance puzzles are stated in terms of returns. To make that connection, one can
transform (9) to a relation linking asset returns to investment growth. Many return puzzles
are mirrored in investment growth as the q theory suggests.47
47
Cochrane (1991b), (1996) (2007a), Lamont (2000) Li, Livdan and Zhang (2008), Liu, Whithed and
Zhang (2009), Belo (2010), Jermann (2010), Liu and Zhang (2011).
25
Q theory also reminds us that supply as well as demand matters in setting asset prices.
If capital could adjust freely, stock values would never change, no matter how irrational
investors are. Quantities would change instead.
Im not arguing that consumption or investment caused the boom or the crash. Endowmenteconomy causal intuition does not hold in a production economy. These first-order conditions
are happily consistent with a view, for example, that rather small losses on subprime mortgages were amplified by a run on the shadow banking system and flight to quality,48 which
certainly qualifies as a friction. The first-order conditions are consistent with many other
views of the fundamental determinants of both prices and quantities. But the graphs do
argue that asset prices and discount rates are much better linked to big macroeconomic
events than most people think (and vice versa). They suggest another important amplification mechanism: If people did not become more risk averse in recessions, and if firms could
quickly transform empty houses into hamburgers, asset prices would not have declined as
much.
I also dont pretend to have perfect versions of either of these first-order conditions, let
alone a full macro model that captures value or the rest of the factor zoo. These are very
simple and rejectable models. Each makes a 100% R2 prediction that is easy to formally
reject. The point is only that research and further elaboration of these kinds of models, as
well as using their basic intuition as an important guide to events, is not a hopeless endeavor.
E. Comparisons
Conversely, I think the other kinds of models, though good for describing particular anomalies, will have greater diculty accounting for recent big-picture asset pricing events.
We see a pervasive, coordinated rise in the premium for systematic risk, common across
all asset classes, and present in completely unintermediated and unsegmented assets.49 For
example, Figure 11 plots government and corporate rates, and Figure 12 plots the baa-aaa
spread with stock prices. You can see a huge credit spread open up and fade away along
with the dip in stock prices.
Behavioral ideas narrow framing, salience of recent experience, and so forth are good
at generating anomalous prices and mean returns in individual assets or small groups. They
dont easily generate this kind of coordinated movement that looks just like a rise in risk
premium. They dont naturally generate covariance either. For example, extrapolation
generates the slight autocorrelation in returns that lies behind momentum. But why should
all the momentum stocks then rise and fall together the next month, just as if they are
exposed to a pervasive, systematic risk?
Finance models dont help, of course, because were looking at variation of the factors
which they take as given.
48
49
Cochrane (2011)..
The systematic adjective is important. People dont seem to drive more carefully in recessions.
26
baa,aaa
10
6
BAA
5
AAA
4
20 Yr
3
2
5 Yr
0
2007
1 Yr
2008
2009
2010
2011
3.5
2.5
1.5
0.5
2007
2008
2009
2010
27
Again, macro isnt everything understanding the smaller puzzles is important. The
point is only that looking for macro underpinnings for discount rate variation, through fairly
simple models, isnt as hopelessly anachronistic as many seem to think.
F. Arbitrages?
One of the nicest pieces of evidence for segmented or institutional views is that arbitrage
relationships were violated in the financial crisis.50 Unwinding the arbitrage opportunities
required one to borrow dollars, which intermediary arbitrageurs could not do.
Figure 13 gives one example. CDS plus Treasury should equal a corporate bond, and
usually does. Not in the crisis.
6
5
Bond
Percent
CDS
0
Feb 07
Jun 07
Sep 07
Dec 07
Apr 08
Jul 08
Oct 08
Figure 13: Citigroup CDS and Bond spreads. Source: Fontana (2010).
Figure 14 gives another example, covered interest parity. Investing in the US vs. investing
in Europe and returning the money with forward rates should yield the same thing. Not in
the crisis. In both cases, profiting from the arbitrage requires one to borrow dollars, which
was dicult in the crisis.
Similar patterns happened in many other markets, including even US treasuries.51 Now,
any arbitrage opportunity is a dramatic event. But in each case here the dierence between
the two ways of getting the same cashflow is dwarfed by the overall change in prices. And,
though an arbitrage, the price dierences are not large enough to attract long only deep
pocket money. If your precious cash is in a US money market fund, 20 basis points in the
depth of a financial crisis is not enough to get you to listen to the salesman oering oshore
investing with an exchange-rate hedging program.
50
51
28
1
swap
libor
0
Feb 07
Jun 07
Sep 07
Dec 07
Apr 08
Jul 08
Oct 08
Jan 09
May 09
Figure 14: Three-month Libor and FX swap rate. Source: Baba and Packer (2009).
So maybe its possible that the macro view still builds the benchmark story of overall
price change, with very interesting spreads opening up due to frictions. At least we have a
theory for that. Constructing a theory in which the arbitrage spreads drive the coordinated
rise in risk premium seems much harder.
The price of coee displays arbitrage opportunities across locations at the ASSA meetings.
(The AFA gave it away for free downstairs while Starbucks was selling it upstairs.) The
arbitrage reflects an interesting combination of transactions costs, short-sale constraints,
consumer biases, funding limits, and other frictions. Yet we dont dream that this fact
matters for big-picture variation in worldwide commodity prices.
Cochrane (2001), (2003), (2005b), Garber (2000), Krishnamurthy (2002), OHara (2008), Scheinkman
and Xiong (2003).
29
450
400
NASDAQ Tech
350
300
250
NASDAQ
200
150
NYSE
100
50
Feb98
Sep98
Mar99
Oct99
Apr00
Nov00
May01
Dec01
Figure 15: Nasdaq Tech, Nasdaq, and NYSE indeces Source: Cochrane (2003).
Dollar volume
800
700
NASDAQ Tech
600
500
400
NASDAQ
300
200
NYSE
100
Feb98
Sep98
Mar99
Oct99
Apr00
Nov00
May01
Dec01
Figure 16: Dollar volume in Nasdaq tech, Nasdaq, and NYSE. Source: Cochrane (2003).
When share supply is small, and trading demand is large, markets can drive down the
discount rate or drive up the price of highly-traded securities, as they do for money. These
eects have long been seen in government bonds, for example in the Japanese benchmark
eect, the spreads between on-the-run and o-the-run Treasuries, or the spreads between
Treasury and agency bonds.53 Could these eects extend to other assets?
53
Boudoukh and Whitelaw (1991), Longsta (2004), Krishnamurthy and Vissing-Jorgensen (2010).
30
Figures 15 and 16 are suggestive. The stock price raise and fall of the late 1990s was
concentrated in Nasdaq and Nasdaq Tech. The stock volume rise and fall was concentrated
in the same place. Every asset price bubble defined here by peoples use of the label
has coincided with a similar trading frenzy, from Dutch tulips in 1620 to Miami condos in
2006.
Is this a coincidence? Do prices rise and fall for other reasons, and large trading volume
follows, with no eect on price? Or is the high price equivalently a low discount rate
explained at least in part by the huge volume; by the value of shares in facilitating a frenzy
of information trading?
To make this a deep theory, we must answer why people trade so much. Verbally, we
know the answer: The markets we study exist to support information-based trading. Yet,
we really dont have good models of information-based trading.54 Perhaps the question how
information is incorporated in asset markets will come back to the center of inquiry.
V. Applications
Finance is about practical application, not just deep explanation. Discount rate variation
will change applications a lot.
A. Portfolio theory
A huge literature explores how investors should exploit the market-timing and intertemporalhedging opportunities implicit in time-varying expected returns.55
But the average investor must hold the market portfolio. We cant all market-time, we
cant all buy value, and we cant all be smarter than average. We cant even all rebalance.
No portfolio advice other than hold the market can apply to everyone. A useful and
durable portfolio theory must be consistent with this theorem. Our discount-rate facts and
theories suggest one, built on dierences between people.
Consider Fama and Frenchs (1996) story for value. The average investor is worried
that value stocks will fall at the same time his or her human capital falls. But then some
investors (steelworkers) will be more worried than average, and should short value despite
the premium; some others (tech nerds) will have human capital correlated with growth
stocks and buy lots of value, eectively selling insurance. A two-factor model implies a
three-fund theorem, a three-dimensional multifactor ecient frontier as shown in Figure
17.56 Investors have a dicult problem to figure out how much of three funds to hold.
And now we have dozens of such systematic risks for each investor to consider. Timevarying opportunities create more factors, as habits or leverage risk aversion shift some
54
31
Figure 17: Multifactor ecient frontiers. Investors minimize variance given mean and covariance with the extra factor. A three-fund theorem emerges (left). The market portfolio is
multifactor ecient, but not mean-variance ecient (right).
investors risk aversion through time more or less than others. Unpriced factors are even
more important. Our steelworker should start by shorting a steel-industry portfolio, even if
it has zero alpha. Such a zero-alpha factor is actuarially fair insurance. We academics should
understand the variation across people in risks that are hedgeable by systematic factors, and
find low-cost portfolios that span that variation.57 Yet weve spent all our time looking for
priced factors that are only interesting for the measure-zero mean-variance investor!
All of this sounds hard. Thats good! We finally have a reason for a fee-based tailored
portfolio industry to exist, rather than just to deplore it as folly. We finally have a reason
for us to charge fat tuitions to our MBA students. We finally have an interesting portfolio
theory that is not based on chasing zero-sum alpha.
A.1. State Variables
Discount-rate variation means that state-variable hedging should matter. It is almost completely ignored in practice. Almost all hedge funds, active managers, and institutions still
use mean-variance optimizers. This is particularly striking given that they follow active
strategies, predicated on the idea that expected returns and variances vary a lot over time!
Perhaps state variable hedging seems nebulous, and therefore maybe small and easy to
ignore. Heres a story to convince you otherwise. Suppose you are a highly risk averse
investor, with a 10 year horizon. You are investing to cover a defined payment, say your 8
year olds future tuition at the University of Chicago. The optimal investment is obviously
57
32
a 10-year zero-coupon indexed Treasury (TIP).58 Figure 18 tracks your investment through
time.
Suppose now that bond prices plunge, and volatility surges, highlighted in the graph.
Should you sell in a panic, to avoid the risk of further losses? No. You should tear up
the statement. Short term volatility is irrelevant. Every decline in price comes with a
corresponding rise in expected return. Evaluating bonds with a one-period mean-variance,
alpha-beta framework is silly though a surprising amount of the bond investing world does
it!
Price of a bond that matures in year 10 simulation
100
90
80
bond price
70
60
50
40
30
20
10
0
5
time, years
10
Thats pretty obvious, but now imagine yourself a stock investor in December 2008 say,
your universitys endowment. Stocks plummeted, shown in Figure 19, and stock volatility
in Figure 20 rose dramatically, from 16% to 70%.
Should you sell, to avoid the risks of further losses? The standard formula says so.
Picking a mean return and risk aversion to justify 60% stocks in normal times, you should
reduce the equity share to 4%:
Equity Share =
1 004
1 004
1 ( )
06 =
= 004?
2
2
( )
2 018
2 0702
(You might object that mean returns rose too. But they would have to have risen to
4 0702 0182 = 60% for this formula to tell you not to change allocation. You also may
58
33
S&P500
10
10
20
30
40
50
What to do???
60
2007
2008
2009
2010
montly vol.
vix
What to do??
70
60
Percent
50
40
30
20
10
2007
2008
2009
2010
Figure 20: Volatility. VIX index, and 20 day realized daily volatility
object that many investors including endowments had leverage, tenured professor salaries to
pay or other habit-like considerations for becoming more risk averse. Fair enough, but then
one-period mean-variance theory is particularly inappropriate in the first place.)
But not everyone can do this the market didnt fall 93%. If youre selling, who is buying?
Is everyone else being stupid? Does it make sense to think that the market irrationally
overvalued in the midst of the financial crisis?
The answer, of course, is that one-period mean-variance analysis is completely inappropriate. If the world were i.i.d., volatility couldnt change in the first place. Stocks are a
34
bit like bonds; price/dividend drops increase expected returns.59 To some extent, short
run volatility doesnt matter to a long-run investor. State-variable hedging matters a lot,
even for simple real-world applications. And, by ICAPM logic, we should therefore expect
multiple priced factors. Time-series predictability should be a strong source of additional
pricing factors in the cross section, and aect portfolios.
A.2. Prices and payos
Or maybe not. Telling our bond investor to hold 10 year zeros because their price happens
to covary properly with state variables for their investment opportunities just completely
confuses the obvious. Its much clearer to look at the final payo and tell him to ignore price
fluctuations. Maybe dynamic portfolio theory overall might get a lot simpler if we look at
payo streams rather than looking at dynamic trading strategies that achieve those streams.
If you look at payo streams, its totally obvious that an indexed perpetuity (or annuity)
is the risk-free asset for long-term investors, despite arbitrary time-varying return moments,
just as the ten-year zero was obviously the riskfree asset for my bond investor. Its interesting
that coupon-only TIPS are perceived to be an exotic product, or a way to speculate on
inflation, not the benchmark riskfree asset for every portfolio in place of a money-market
investment.
How about risky investments?
quadratic
max
{ }
X
=0
1
( )2
2
it turns out that we can still use two-period mean-variance theory to think about streams
of payos, (loosely, streams of dividends) no matter how much expected returns vary over
time.
Every optimal payo stream combines an indexed perpetuity and a claim to the aggregate
dividend stream. Less risk averse investors hold more of the claim to aggregate dividends,
and vice versa.
Optimal payos lie on a long-run mean / long-run variance frontier, where I define long
run means ()
that sum over time as well as states,
()
=
1 X
(+ )
1 =0
State variables disappear from portfolio theory, just as they did for our 10 year TIP
investor, once he looked at the 10 year problem.
If our stock market investor thought this way, he would answer I bought the aggregate
dividend stream. Why should I buy or sell? I dont look at the statements. This is a lot
59
60
35
simpler to explain and implement than deep time series modeling, value function calculation,
and optimal hedge portfolios!
If investors have outside income, they first short a payo stream most correlated with
their outside income stream, and then hold the mean-variance ecient payos. Calculating
correlations of income streams this way may be easier than trying to impute discount-rate
induced changes in the present value of outside income streams, in order to calculate returnbased hedge portfolios.
If investors have no outside income, long-run expected returns (payos divided by initial
prices) line up with long-run market betas. A CAPM emerges, despite arbitrary timevariation in expected returns and variances. ICAPM pricing factors fade away as we look
at longer horizons. If investors do have outside income, an average-outside-income payo
emerges as a second priced factor, in the style of Fama and Frenchs (1996) human capital
story for the value eect.
Of course, quadratic utility is a troublesome approximation, especially for long-term
problems. Still, this simple example captures the possibility that a price and payo approach
can give a much simpler view of pricing and portfolio theory than we get by focusing on
the high-frequency dynamic trading strategy that achieves those payos in a given market
structure.
I tried telling a hedge fund manager, You dont have alpha. I can replicate your returns
with a value-growth, momentum, currency and term carry, and short-vol strategy. He said,
Exotic beta is my alpha. I understand those systematic factors and know how to trade
them. You dont. He has a point. How many investors have even thought through their
exposures to carry trade or short volatility systematic risks, let alone actually can program
computers to execute such strategies as passive, mechanical investments? To an investor
who hasnt heard of it and holds the market index, a new factor is alpha. And has nothing
to do with informational ineciency.
Most active management and performance evaluation just isnt well described by the
alpha-beta, information-systematic, selection-style split anymore. There is no alpha. There
is just beta you understand and beta you dont understand, and beta you are positioned to
buy vs. beta you are already exposed to and should sell.
61
Mitchell and Pulvino (2001), Asness, Krail and Liew (2001), Agarwal,and Naik (2004).
36
EquitMktNeut
50
40
30
20
10
10
20
30
40
HF
rmrf
50
1994
1996
1998
2000
2002
2004
2006
2008
2010
Figure 21: One year excess returns of the equity market neutral hedge fund index and the
CRSP value-weighted portfolio. Data source: hedgeindex.com and CRSP.
Expected payout
+ [( ) ]
with a 6% market premium. All of which, we now know, is completely wrong. The market
premium isnt always 6%, but varies over time by as much as its mean. Expected returns
dont line up with CAPM betas, but rather with multifactor betas. And since expected
returns change over time, the discount rate is dierent for cashflows at dierent horizons.
Its interesting that investment decisions got so close to right anyway, with high investment following high stock prices. (Remember Figure 10.) Evidently, a generation of our
MBAs figured out how to jigger the numbers and get the right answer despite a dramatically
wrong model. Perhaps what we often call irrational cash flow forecasts, optimistic in good
times and pessimistic in bad times, are just a good way to oset artificially constant discount
rates. Or perhaps they understood the Q theory lecture and just follow its advice.
I dont think the answer lies in multifactor betas62 or discounting with dynamic present
value models and time-varying risk premia, at least not yet. Capital budgeting is a relative
pricing exercise we want to use available information in asset markets to help us decide
what the discount rate for a given project should be. For this purpose, simply looking
at average returns of similar securities is enough. Understanding discount rates as a
function of characteristics or, better, understanding valuations directly as a function of
62
37
characteristics (the use of comparables) may end up being more fruitful. We dont
have to explain discount rates relate expected returns to betas, and understand their deep
economics in order to use them. We dont need an all-purpose model of everything to
extend prices from known assets to a new one. Even when discount rates are explained,
the characterization (characteristic models) may be a better measure for practical relativepricing than the explanation (beta models). Conversely, capital budgeting gives the same
answer if discount rates are wrong. When you shop for a salad, all you care about is
the price of tomatoes. Whether tomatoes are expensive because the trucks got stuck in bad
weather, or because of an irrational bubble in the tomato futures market makes no dierence
to your decision.
Many procedures in accounting, regulation and capital structure implicitly assume that
returns are independent over time, and hence that prices only reflect cashflow information.
Suppose that a firm has a single cashflow in 10 years, and is funded by a zero-coupon bond
and equity. In most accounting, capital structure, and regulation we would use the stock
and bond prices to calculate the probability and distance to default. But if prices decline
because discount rates rise, that fact has no implication for the probability or distance to
default.
Perhaps banks complaint that low asset prices represent illiquidity or temporarily
depressed valuations rather than insolvency a lesser chance of making future interest and
principal repayments make some sense. Perhaps capital requirements do not have to
respond immediately to such events. Perhaps hold to maturity accounting is not as silly
as it sounds. Perhaps the fact that firms change capital structures very slowly in response
to changes in equity valuations makes some sense.63
Of course, in such an event the risk-neutral probability of default has risen. Maybe
regulators, bondholders, and capital structure should respond to a rise in the state-price
of the default event exactly as they respond to a rise in the real probability of that event.
Maybe, but at least its a very dierent issue and worth asking the question.
I am not arguing that mark-to-market accounting is bad, or that fudging the numbers
is a good idea. The point is only that what you do with a mark-to-market number might
be quite dierent in a world driven by discount-rate variation than one driven by cashflow
variation.64 The mark-to-market value is no longer a sucient statistic. A loss of value
with a rise in expected return has dierent implications than a loss of value with a decline
in expected return. Decisions need to incorporate more information, not less
The view that the stock price is driven by expected earnings lies behind stock-based
executive compensation as well. Its already a bit of a puzzle that executives should be
forced to hold the systematic risks due to recessions, market betas, or commodity-price
exposures, about which they can do nothing. Understanding that a large fraction of stock
returns reflect changes in discount rates or new-factor beta exposures makes the logic of such
incentives even more curious. Perhaps stock-based compensation has less to do with eort
and operating performance, but more with incentives for risk management or tax treatment.
63
64
Welch (2004).
Heaton, Lucas and McDonald (2009).
38
D. Macroeconomics
Large variation in risk premia implies exciting changes for macroeconomics.
Most of macroeconomics focuses on variation in a single intertemporal price, the interest rate, which intermediates saving and investment. Yet in the recent recession, as shown
in Figure 11, interest rates paid by borrowers (and received by any investors willing to lend)
spiked up, while short-term government rates went down. Recessions are all about changes
in credit spreads, about the willingness to bear risk and the amount of risk to be borne, far
more than they are about changes in the desire for current vs. future certain consumption.
Most of the Federal Reserves response consisted of targeting risk premiums, not changing
the level of interest rates or addressing a transactions demand for money.
Macroeconomics and finance have thought very dierently about consumer (we call them
investors) and firm behavior. For example, the consumers in the Cambpell and Cochrane
(1999) habit model balance very strong precautionary saving motives with very strong
intertemporal substitution motives, and have large and time-varying risk aversion. Their
behavior is very far from the permanent-income intuition (or constrained alternative) in
macroeconomic thinking.
As one simple story, macroeconomists often think about how consumers will respond
to a change in wealth, coming from a change in stock prices or house prices. Financial
economists might suspect that consumers will respond quite dierently to a decline in value
coming from a discount rate rise a temporary change in price with no change in capital
stock or cashflow than one that comes from a change in expected cashflows, or destruction
of physical capital stock.
Financial models also emphasize adjustment costs or irreversibilities: If firms can freely
transform consumption goods to capital, then stock prices (q) are constant. Yet, most real
business cycle literature following King, Plosser and Rebelo (1988) left out adjustment
costs, because they didnt need them to match basic quantity correlations. The first round
of new-Keynesian literature abstracted from capital altogether, and much work in that
tradition continues to do so. Figure 10 pretty strongly suggests q is not constant. Together
with the regression evidence of Table I, and interest rates in Figure 11, it suggests that
variations in the risk premium drive investment, not variation in the level of riskfree interest
rates emphasized by macro policy-makers. Adjustment costs lead to basic dierences in
analysis. For example, without adjustment costs, the marginal product of capital 0 () can
be negative, clashing with the zero bound on nominal rates. With adjustment costs, the
price of capital can fall, giving a positive real rate of interest.
Formal macroeconomics has started to introduce some of the same ingredients that macrofinance researchers are using to understand discount rate variation, including new preferences, adjustment cost or other frictions in capital formation, and financial frictions in credit
markets.65 And macroeconomic models with financial frictions are all the rage since the
65
For example Christiano, Eichenbaum and Evans (2005). However, this is also a good example of remaining dierences. They use a one-period habit, which does not generate slow-moving expected excess returns,
and an adjustment cost tied to investment growth not the investment/capital ratio, which does not generate
the q theory predictions of Figure 10 and related finance literature.
39
financial crisis. Still, we are a long way from a single general-equilibrium model that matches
basic quantity and price facts.
Everyone is aware of the question. The job is just hard. Macroeconomic models are
technically complicated. Macroeconomic models with time varying risk premia are much
harder. Adding financial frictions while maintaining the models dynamic intertemporal
character is harder still. At a deeper level, successful grand synthesis models do not
consist of just mixing all the popular ingredients together and stirring the pot; they must
maintain the clear quantitative-parable feature of good economic analysis.
An asset-pricing perspective also informs the interaction between monetary and fiscal
policy. From a finance perspective, nominal government debt is equity in the government:
it is the residual claim to primary fiscal surpluses. Hence, the price level must satisfy the
standard asset pricing equation,
X
Debt
=
+ (real primary surplus+ )
Price level
=0
(10)
Inflation can absorb shocks to surpluses, just as as equity absorbs shocks to profit streams.
This fact is at least an important constraint on monetary policy, especially in a time of
looming deficits.66 Fiscal events can lead to inflation that the Fed is powerless to avoid.
The analogy to stocks also suggests that variation in the discount rate + for government
debt is important: A flight to quality lowers the discount rate for government debt, raising
the right hand side of (10). People want to hold more government debt, which means getting
rid of goods and services, i.e. lower aggregate demand. This story links the rising risk
premium which finance people see as the core of a recession with the decline in aggregate
demand which macroeconomists see. The standard corporate finance perspective also
illuminates government debt maturity structure and denomination: Foreign currency debt
is debt, that must be repaid or defaulted. Domestic-currency debt is equity, which can be
inflated. Long-term debt allows bond prices to temporarily absorb shocks to future surpluses,
postponing the immediate inflation when short-term debt cannot be refinanced.
VI. Conclusion
Discount rates vary a lot more than we thought. Most of the puzzles and anomalies that we
face amount to discount rate variation we dont understand. Our theoretical controversies
are about how discount rates are formed. We need to recognize and incorporate discount
rate variation in applied procedures.
We are really only beginning these tasks. The facts about discount rate variation need
at least a dramatic consolidation. Theories are in their infancy. And most applications still
implicitly assume i.i.d. returns and the CAPM, and therefore that price changes only reveal
cashflow news. Throughout, I see hints that discount-rate variation may lead us to refocus
analysis on prices and long-run payo streams rather than one-period returns.
66
40
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49
Appendix
I. Present values and identities
A. Return identity
To keep the presentation self-contained, I start with a derivation of the Campbell-Shiller
(1988) linearization. The return is by definition,
+1
1
+
+1 +1
+1 + +1
=
+1 =
+1 = log 1 + +1 + + +1
where log( ), = log( ) = log( ). I Taylor expand the first term about
a constant and = log( ) This constant need not be the mean. One can use
the identity to examine cross-sectional variation in dividend yields without using a dierent
constant of approximation for securities with dierent average dividend yield.
+1 = log(1 + )
Denoting
,
1+
(+1 ) + + +1
1 +
(11)
where
= (1 ) log(1 ) log()
In time-series applications where we will only consider second moments we interpret symbols
as deviations from means and ignore leaving
+1 = +1 + + +1
50
(12)
Iterating forward,
=
=1
1 + + +
=1
Assuming the latter term goes to zero the transversality condition which rules out
rational bubbles we have
=
X
=1
1 +
(13)
=1
This is an ex-post identity, so it also holds in conditional expectations using any information
set.
C. Dividend construction.
I create dividends from the CRSP annual return series with and without dividends,
+1 + +1
+1
; +1
Then,
+1
+1
=
1
+1
+1
By using an annual horizon, I avoid the strong seasonal in dividend payments.
Annual dividend growth also includes some return information, because this definition
one reinvests dividends to the end of the year at the market return. Annual sums of dividends
are a good deal less volatile. However, if one uses sums of dividends over the year, then the
identity +1 = (+1 + +1 ) does not hold. Its nice to use data definitions for which
identities hold!
This definition of dividends has a second practical advantage. Consider the sharp fall in
stocks in the Fall of 2008. Using a simple sum of past dividends, we would see a decline in
price/dividend ratio as large as the decline in stock market values. But much of that decline
surely reflected news that dividends in 2009 were going to fall dramatically, news reflected
in the return. By reinvesting dividends to the end of the year, the dividend series is lower
than the sum; this price-dividend ratio already includes the information that dividends will
decline next year. The price-dividend ratio fell a good deal less than prices, and therefore
better corresponds to expected returns.
I construct dividend growth by
(+1 +1 )
+1
( )
51
For the VAR in Tables II-IV I use instead dividend growth implied by the identity (11),
+1 = + +1 + +1
Actual dividend growth gives very similar results. However, this construction means that
Cambpell-Shiller approximate identities hold exactly, so it is easier to see the identities in the
results. To make identities hold, its better to use pure returns rather than infer returns
from dividend growth, otherwise approximation errors can show up as magic investment
opportunities.
II. VARs
A. Shock definition
I identified the shocks in Figure 5 by setting changes to the other variables in turn equal
to zero. The return identity (12) means that therefore some of the shocks must come with
contemporaneous shocks to returns.
The dividend growth shock is a shock to dividend growth with no change in dividend
yield or cay. Hence, it must come with a contemporaneous return shock,
+1 = 1
+1 = 0 +1 = 0 +1 = 1
If dividend growth rises and dividend yields do not change, you just made a good return.
The dividend yield shock has no change in dividend growth or cay. If dividends dont change
and rises, it means and fell a lot. Intuitively, a pure rise in discount rates lowers
current return so it can raise subsequent returns.
+1 = 0
+1 = 1 +1 = 0 +1 =
The cay shock is a change in with no change in dividend yield or dividend growth
, and hence no change in return .
+1 = 0
+1 = 0 +1 = 1 +1 = 0
I choose this definition of shocks because it leads to nicely interpretable responses, e.g.
cashflow and discount rate. Because dividends remain roughly unpredictable, this short
run identification gives almost the same result as a long run identification. Precisely, if
1 + = 0
=1
we would have gotten nearly the same result. The resulting shocks are nearly uncorrelated,
which is also convenient.
52
This VAR is very simple, since I left dividend growth and returns out of the right hand
side. My purpose is to distill the essential message of more complex VARs, not to deny that
there may be some information in additional lags of these variables.
=1
suggests that an extra variable can only help dp to forecast long horizon returns if it forecasts
long horizon dividend growth; it can help to forecast one year returns by changing the term
structure of return forecasts as well. Here I show how that intuition applies algebraically to
multiple regression coecients and the impulse response function.
Regressing both sides of (13) on and , we obtain the generalized restriction on
long-run multiple regression coecients,
1 =
0 =
(14)
(15)
X
=1
1 + = +
+ +
1 + = +
+ +
=1
Equation (14) is the same as before, now applied to the multiple regression coecient.
Equation (15) expresses the idea that a new variable can only help to forecast long-run
returns if it also helps to forecast long-run dividend growth. The extra dividend growth and
return forecasts will be perfectly negatively correlated. In this way, extra long-run dividend
growth forecastability means more long-run return forecastability, not less.
In terms of individual long-horizon regressions
()
+ = ()
+ + +
53
X
=1
X
=1
1 ()
1 ()
=1
()
()
=1
(1)
()
1
=1
0 =
X
=1
1 ()
()
=1
()
=1
()
where denotes the response of + to a shock. This fact lets me easily interpret
the change in forecastability by adding cay, in the context of the present value identity, by
plotting the impulse responses. The numbers in Figure 5 are terms of this decomposition.
()
()
2
1
(
+ )
=1
1
( =1 + )
cay
eqis
svar
ik
dfy
2.21
-0.71
1.48
-5.30
5.25
(1.73) (-2.53) (3.40) (-0.85) (1.86)
0.13
0.10
0.19
0.15
0.11
0.13
(2.61) (1.82) (3.75) (3.05) (2.16) (2.53)
0.10
0.16
0.19
0.15
0.11
0.13
0.52
0.17
0.46
0.13
0.49
0.16
0.42
0.11
0.53
0.17
0.49
0.14
Table AI. Multiple return-forecasting regressions and implied variance of longhorizon returns.
+1 = + + + +1
54
Data are from Welch and Goyal, 1947-2009. I calculate the variance of longhorizon expected returns and dividend growth from a bivariate VAR, and using
actual (not identity) dividend growth forecasts. Equis, Percentage Equity Issuance is the ratio of equity issuing activity as a fraction of total issuing activity.
Svar is stock variance, computed as sum of squared daily returns on the S&P
500. Ik is the investment to capital ratio, the ratio of aggregate (private nonresidential fixed) investment to aggregate capital for the whole economy. Dfy, the
default yield spread, is the dierence between BAA and AAA-rated corporate
bond yields.
+1
+1
+1
+1
0.13
0.03
0.93
-0.07
0.26
0.35
0.10
0.10
( )
(2.45)
(0.62)
(24.7)
(-1.85)
( )
(1.83)
(3.27)
(0.85)
(0.85)
())
2
( ())% (
()
0.15 6.76
0.65
0.14 4.98
0.90
0.91
0.06
Table AII. Forecasts using dividend yield and change in dividend yield. CRSP
value weighted return 1947-2009. = 1
The change in dividend yield helps the return forecast, increasing 2 from 0.09 to 0.15,
and correspondingly increasing the more interesting measures of expected return variation.
The change in dividend yield really helps to forecast dividend growth, with a 3.27 t
statistic, 5% standard deviation of forecast and forecast that varies by 90% of the mean.
The 0.10 autoccorrelation in however suggests that this will be a very short-lived
signal, one with little impact on forecasts of long-run dividend growth or returns, and thus
to our view of the sources of price-dividend ratio volatility.
Similarly, while individual and coecients dont look big and dont have much
pattern, they can nonetheless help as a group, or by sensibly restricting the pattern of lagged
coecients. In this vein, Lacerda and Santa-Clara (2010) and Koijen and van Binsbergen
(2009) find that moving averages of past dividend growth help to forecast both returns
and dividend growth (as they must, given the present value identity), almost doubling the
return-forecast 2 .
55
E. VAR calculations
To find regression coecients implied by a first-order VAR as in Table II, I run
+1 = + +1
+1 = + +1
(16)
+1 = +
+1
(17)
Then I report
()
1 ()
=
1
To calculate long run regression coecients as in Table IV, with = , I write the
VAR as
+1
+1
=
+
+1
+1
+1
+1
=
+
+1
+1
then
+1
+1
=1
= ( )
F. Univariate implications
While extending the VAR to additional variables adds a lot, the univariate implications of the
VARs are much less than one might think. The middle panel of Figure 5 implies a completely
temporary component of prices; if prices fall and dividends do not, that price movement is
expected completely to melt away. However, the implied univariate representation of returns
is almost completely independent over time. Returns are predictable by dividend yields, but
not by past returns. As a result, stock return volatility does not decline substantially with
investment horizon and stocks are not safer in the long run. One has to see the state variable
to have any eect on forecastability or classic portfolio theory.
The reason is easy to see in a simplified example. Write the VAR as
+1 = + +1
+1 = 0 + +1
+1 = +
+1
Examine (1 )+1
(1 )+1 = (1 ) + +1
(1 )+1 = (1 )
+ +1 +1
(1 )+1 =
+1 + +1 +
[(1 )+1 ] = 1 + 2 2 = 1 + 2 2 + 2
[(1 )+1 (1 ) ] = 2 = 2 + 2
Hence, = and returns are uncorrelated over time,
+1 = +1
2 (+1 + +2 + + + ) = 2 2 ()
In general, with 6= , we still have very near (between and in fact), so returns
follow an ARMA with very slight mean-reversion and a large permanent component.
+
() ( )
57
2
2
2
2 2
+
2
2 ( ) = 2 + 2 =
()2
( )
2 ( )2 + 2 (2)
Davis, Fama, and French (2000), Cambpell and Vuolteenaho (2004), Ang and Chen (2007), Fama and
French (2006).
58
19632009
19261963
1
V
Average Return
0.8
8
7
0.6
8 9
1.2
5 6
7
32
G 4
0.8
6
5 342
0.6
0.4
G
0.4
0.2
0.2
0
Rf
0
0.2
0.4
0.6
Betas
0.8
0 Rf
0
0.5
1
Betas
1.5
Figure 22: Value eect before and after 1963. Average returns on Fama - French 10 portfolios
sorted by book/market equity vs. CAPM betas. Monthly data. Source: Ken Frenchs
website.
1.
2.
3.
4.
5.
size
Cross section
-0.030
Pooled
-0.022
Time dummies
-0.031
Portfolio dummies -0.087
Pooled
-0.030
bm size
0.27
0.55
0.29
1.48
0.46 -0.38
bm
1.11
+1
= +( )+( )+ + +( 12 )+( 12 )
59
Terms in parentheses only appear in some regressions. is log(market equity/total market equity). is log(book/market). Monthly data 1947-2009.
Data from Ken Frenchs website.
The second row of Table AIII gives a pooled forecasting regression, which is the most
natural way to integrate time series and cross section. The size coecient is a little smaller,
and the bm coecient is much larger.
To diagnose the dierence between the cross-section and pooled regressions, rows 3 and 4
present a regression with time dummies and a regression with portfolio dummies. Variation
over time in a given portfolios bm is a much stronger signal of return variation than the
same size variation across portfolios in average bm.
When we run such regressions for individual firms, we cant use dummies, since the
average return of a specific company over the whole sample is meaningless. The goal of this
regression is to mirror portfolio formation and remove firm-name completely from the list of
characteristics. The last line of Table AIII gives a way to capture the dierence between timeseries and cross section without dummies it allows an independent eect of recent changes
in the characteristics. This specification accounts quite well for the otherwise unpalatable
time and portfolio dummies. The portfolio dummy regression coecient that captures timeseries variation is quite similar to the sum of the level and recent-change coecients. It is
also gratifyingly similar to the recent-change eect in aggregate dividend-yield regressions
of Table AII. One could of course capture the same phenomenon with portfolios, by sorting
based on level and recent change of characteristics. But my goal is to explore the other
direction of this equivalence.
Next, we want to run regressions like this on individual data, and find similar characterization of the covariance matrix as a function of characteristics. Then, we can expand to
multiple right-hand variables.
60
14
12
return
d, identity
d, direct
D/P
10
2
growth
5
6
B/M portfolio number
value
Figure 23: Average return +1 , dividend growth +1 , and dividend yield for the Fama
- French 10 book/market portfolios, 1947-2008. The dashed line gives mean dividend
growth implied by the approximate identity +1 = +1 + +1
and imposing stationarity so ( ) = (+1 ),
= (1 ) + ( )
Figure 23 shows that value portfolio returns come roughly half from greater dividend growth
and half from a larger average dividend yield.
Our objective is to produce variance decompositions across time and securities as with
the market return. Flipping this around, we have
=
1
( )
1
(18)
The same observation corresponds to a fairly extreme version of the usual surprising result
Low prices high dividend yields correspond to high dividend growth, and thus to even
higher returns.69
The first column of Table AIV expresses the same idea in a purely cross-sectional regression. From (18), the coecients in such a regression obey
1=
1 1
(19)
where the are the cross-sectional regression coecients of the terms in (18). We can
interpret these coecients as the fraction of cross-sectional dividend yield variation driven
69
Chen, Petkova and Zhang (2008) section 2.2.2 discuss this puzzle.
61
by discount rates and driven by dividend growth. (Vuolteenaho (2002) uses a dierent
present value identity to understand variation in the book / market ratio directly, rather
than use dividend yields as I have. This is a better procedure for individual stocks, which
often do not pay dividends. I use dividend yields here for simplicity.) The results are quite
similar to the time-series regressions for the market portfolio from Tables 2 - 4: More than
all of the cross-sectional variation in average dividend yields of these portfolios comes from
cross-sectional variation in expected returns (1.33). Expected dividend growth goes the
wrong way low prices correspond to high dividend growth, as seen in Figure 23. (Sample
means obey the identity
1
1
=
+1 +1 +
1
1
The last term is not zero, which is why the coecients in the (1 ) column do not add
up following (19).)
1
1
1
1
1
1
0.92
0.90
0.94
0.94
0.002
We can, of course, ask how much of the time-variation in these dividend yields around
their portfolio average corresponds to return vs. dividend growth forecasts. A regression
that includes portfolio dummies, shown next in Table AIV, addresses this question. The
0.11 return-forecasting coecient for portfolios is almost the same as the return forecasting
coecient for the market as a whole seen in Tables II-IV. The dividend-growth forecast is
also nearly zero. So all variation in book/market sorted portfolio dividend yields over time,
about portfolio means, corresponds to variation in expected returns, much like that of market
returns.
The regression with time dummies, next in Table AIV, paints a dierent picture. The
return coecient is smaller at 0.044, and is smaller as well, so expected returns only
account for 33% of the variation in dividend yields. Finally we see an important dividend
growth forecast, with the right sign, -0.09, accounting for 68% of dividend yield volatility.
The strong contrast of this result with the pure cross sectional regression means that a time
of unusually large cross-sectional dispersion in dividend yields corresponds to an unusually
high dispersion in dividend growth forecasts.
62
1
1
1
1
average dividend growth (+1 ), and dividend yield change on dividend yields
( ), 10 Fama-French ME (size) portfolios. Implied dividend growth is calculated from the approximate identity +1 = +1 + +1 .
63